May 07/15 – Bund bears in their natural habitat
2015-05-07 9am EDT | #BIll Gross #bunds #Germany #Japan #JGB
Over the past week, the German bund market has experienced what amounts to a crash. It was somewhat orderly, with only this morning’s action getting truly squirrelly, but it was a crash nonetheless.
The German 10 year yield has exploded from a level of 0.15% at the end of April, to a high tick of 0.78% this morning. This has all happened over the last six trading days.
Although I was an early bear (too early actually), I think the decline has gotten out of hand, and that shorts should be covering, but I thought that yesterday – so what do I know?
Most market pundits are breathlessly discussing the bund crash and explaining why it will get even worse, so I don’t think I can add anything to the discussion with more hyperbolic extrapolations of the current rout. But I think it is instructive to think back to last month, and remember what the market was thinking.
I know it is easy to forget, but it was only a couple of weeks ago that market pundits were worried about the ECB running out of German bunds to buy! I know, I know – pretty hilarious, right? But that’s what dominated the thinking at the end of April.
A couple of research pieces to remind you:
March 12/2015 – Here's the takeaway from BNP:
Despite the fall in German yields which cause more short-term bonds to become ineligible, when we take into account both the face value adjusted purchases by the ECB and the upcoming bond supply over the next 18 months, the 25% maximum ownership per issue will not necessarily be exceeded. However, for this to be the case, purchases of longer-dated bonds will need to be higher than implied by the simple "weighting by nominal outstanding amounts" of the eligible 2-31y range. This explains the strong flattening of the German curve that we are witnessing this week…
Therefore, for the time being, the problem is one of a scarcity of bonds - where it is difficult to find the all the bonds across the curve that need to be bought - but, if yields keep falling further; eventually it will become a problem of shortage of bonds due to the 25% threshold in terms of ECB ownership - where there is not enough bonds for the ECB to buy the required amounts.
What all of this means is that at the end of the day, depending on how low the ECB manages to drive yields, it could indeed come to pass that a shortage of purchasable assets materializes, leading to what we again emphasize will be a de facto taper. This will effectively prove that central bank ambition must at some point be constrained by market realities and that realization, dear friends, will be a bitter pill for Mario Draghi to swallow.
BNP actually thought the ECB would be forced to taper their QE program because of a lack of bonds to purchase! Stop and think about that for a second. Last month, most research consisted of nothing more than extrapolating the current bund rally indefinitely into the future and coming to the conclusion that eventually the price would get too high, and the ECB would run out of bunds to buy. F’ me.
And it’s not just BNP. This sort of thinking was pervasive:
The ECB's move to restrict PSPP purchases to sovereign bonds with yields at or above the deposit facility rate has far reaching implications for the German bund curve, Citi notes. Specifically, Citi says bunds will be bought until yields converge on -0.20bps.
The -20bp rule means that the Bundesbank and other core NCBs will be buying higher duration paper than other markets such as Italy. It also means that the Buba will have to buy very close to the 25% issue limit in all remaining paper, assuming no change in market value.
The ECB may then have to drop the 25% limit for some issuers and perhaps all - which in practice means that NCBs can buy more of Non-CAC bonds. In other words, by virtue of the fact that a larger percentage of periphery bonds trade with a yield above the -0.20bps threshold (compared to Germany), Bundesbank purchases will skew towards longer-dated paper by comparison. Additionally, the yield floor may make it difficult for Germany to hit asset purchase targets while remaining under the 25% issue cap.
The key takeaway however, is this:
We think that the buying restriction means that large parts of the German curve converge towards -20bp.
To be clear - we are indeed saying that -20bp is a yield target now that will gradually extend along the curve. Both the Bundesbank and private investors are expected to motivate a more concentrated buying squeeze.
In sum, yields on shorter-dated German paper will move up to the deposit facility threshold and with the 10-year yield sitting below 40bps, it won't be long before the entire curve flattens at -0.20bps.
I have long argued that the ECB’s QE was inflationary and it should be unfriendly to the long end of the European bond market. But the market interpreted the QE differently. What amounts to one of the biggest head fakes of all time, the hedgies and other fools piled into the German bund in a failed attempt to front run the ECB. In doing so, they drove the German bund to truly asinine levels. Now they are getting their faces ripped off as the QE effects finally kick in.
There are a couple of lessons to learn from this episode.
The first is a reminder of how quickly the market sentiment can shift. We have gone from “there will be no bunds to buy” to “holy shit, there are absolutely no bund bids out there” in the space of a week. In this day and age of overly aggressive hedge funds desperately trying to squeeze even the tiniest bit of alpha out of any trade, this sort of manic shift is becoming all to common. Bunds should have never been 0.15%. Period. Full stop. That was a stupid price, yet the hedgies were all pushing them up in front of the ECB. When the proper market response finally became evident, the hedgies all piled out at the same time. The move from 0.15% to 0.78% was vicious because 0.15% was so stupidly out of line. That’s what happens when asset prices are moved so far away from fundamental value. There are absolutely zero supporting bids.
The second lesson is to remember that these “analysts” are often simply just extrapolators of the current trend. There were precious few issuing words of caution on the bund’s rise. Instead they were all helping the mindless move higher. Remember that the next time these “experts” tell you what will happen with some asset price. They don’t have any more clue than you do, so don’t let them influence your thinking.
This Bund crash is an important reminder of how quickly these sorts of moves can sneak up on you. Right now there is a belief that although bonds are suffering, stocks will manage through the turmoil. Although I could foresee a bounce from these levels, one of these days, what happened in the bunds will be replicated in the stock market. It is the exact same situation – hedgies and other fast money front running the Central Banks and company buy backs, pushing stocks way above fundamental value. If the music stops, the real bids are lower – much lower. The other trade that could “sneak up on you” just like bunds, is the long gold trade. I know it is popular to shit all over the little yella fella, but one of these days, the market will dramatically reprice gold much higher. When it comes, it will be quick. Precious few hedgies are long gold (in fact most are short) and the squeeze will be equally violent.
Remember, it was only two weeks ago that bunds could only go one way. The years of massive Central Bank monetary expansion have created a very volatile market environment. Anything can happen, and what everyone is expecting is probably the least likely. Just ask the BNP and Citibank Bund analysts…
As usual I am early
As you know, I have been a big bund bear, but yesterday I covered it all . And not only did I cover it, but like an idiot, I bought some German bunds against selling Japanese JGBs short.
Of course I am early – the story of my life. I awoke this morning to the $2 down move in the bund futures with a big “arrrgggghhhhh.” But as I am writing this piece, we have already rallied back close to unchanged, so maybe this morning was the capitulation bottom.
Either way, I really like my long bund short JGB spread trade.
I think the German bund decline is way overdone due to overly aggressive hedge fund selling. Meanwhile, the Japanese JGB market has become a desert that no one trades. But what happened in Germany can happen just as easily in Japan. In fact, it could be even more explosive. Remember the BoJ is the most aggressive Central Bank out there in terms of balance sheet expansion. I know many market participants think that QE means that bonds should rise, but that is just plain wrong.
One of these days, the JGB market will puke even worse than the bunds. Japanese bonds should yield more than German bunds, and with this latest swoon, we now get to put on the spread at 20 basis points in our favour.
This is probably my favourite trade right now.
No wonder Gross is depressed
Yesterday I wrote about Bill Gross’ depressing blog piece (“Sell, you fools!”) . I was a little surprised at how morose he seemed because the week before he nailed the bund decline, proclaiming it the “short of a lifetime” on national TV. At the time I worried that he might goocher my trade because the Market Gods do not take kindly to that sort of grandiose market call. When a trader is over confident, the Gods like to remind him of his fallibility.
Well, the Market Gods did indeed punish Bill for his cockiness. Even though they allowed him to be correct on his “short of the lifetime” call, they did not let him take any money out of the market. In fact, Gross had a terrible couple of weeks – losing 2.1% even though the bund collapsed.
You see Gross didn’t just short bunds like he recommended. Instead he got cute. Gross sold call options, betting on the bund rally petering out. So far so good. But he also sold out of the money put options. These were supposed to be dust, but as the bund sold off more quickly than Gross envisioned, they quickly skirted into the money. All of a sudden, even though Gross was bearish on bunds, he found himself net long.
As a trader there is nothing worse than getting a call right, but still losing money. Seriously. It is demoralizing. You would rather just be wrong.
No wonder Bill is so depressed. The call of a lifetime, and he screws it up. Poor old Bill gets punished by the Market Gods for his bravado. This is just another example of how the markets have changed, and strategies that worked in Bill’s previous lifetime are no longer going to work. Don’t underestimate how much the financial markets have changed. The old guard is not going to navigate you through this topsy turvy messed up world. Bill never thought bunds would go from 0.15% to 0.78% in six sessions – which is exactly why it happened.